Tax Benefits for Oil and Gas Well Owners
Table of Contents
A working interest in an Oil & Gas well can generate several tax benefits and lower your tax liability on your 2011 income tax return.
Marginal production of oil and gas. With soaring gas prices in recent years, many oil and gas wells have positive cash flow. The IRS allows a depletion deduction for the oil and gas
produced from the well. The depletion deduction can be computed either by amortizing the cost of the well (units of production method) or on percentage depletion method—usually, 15% percent of the gross income.
Historically, the IRS limited the depletion deduction to 100% of taxable income. However, the 100% taxable income limitation on percentage depletion
for the marginal production of oil and natural gas also applies to tax years beginning in 2010 and 2011.
Depletion is the using up of natural resources by mining, quarrying, drilling, or
felling. The depletion deduction allows an owner or operator to account for the
reduction of a product's reserves.
There are two ways of figuring depletion: cost depletion and percentage depletion.
For mineral property, you generally must use the method that gives you the larger
If you have an economic interest in mineral property, you can
take a deduction for depletion. More than one person can have an economic interest
in the same mineral deposit.
You have an economic interest if both the following apply.
- You have acquired by investment any interest in mineral deposits.
- You have a legal right to income from the extraction of the mineral to which you must look for a return of your capital investment.
A contractual relationship that allows you an economic or monetary advantage from
products of the mineral deposit is not, in itself, an economic
interest. A production payment carved out of, or retained on the sale of, mineral
property is not an economic interest.
Individuals, corporations, estates, and trusts who claim depletion deductions may
be liable for alternative minimum tax.
Mineral property includes oil and gas wells. For this purpose, the term “property”
means each separate interest you own in each mineral deposit in each separate tract
or parcel of land. You can treat two or more separate interests as one property
or as separate properties. See section 614 of the Internal Revenue Code and the
related regulations for rules on how to treat separate mineral interests.
There are two ways of figuring depletion on mineral property.
Generally, you must use the method that gives you the larger deduction. However,
unless you are an independent producer or royalty owner, you generally cannot use
percentage depletion for oil and gas wells.
To figure cost depletion you must first determine the following.
Basis for depletion. To figure the property's basis
for depletion, subtract all the following from the property's adjusted basis.
- The property's basis for depletion.
- The total recoverable units of mineral in the property's natural deposit.
- The number of units of mineral sold during the tax year.
Adjusted basis. The adjusted basis of your property is your
original cost or other basis, plus certain additions and improvements, and minus
certain deductions such as depletion allowed or allowable and casualty losses. Your
adjusted basis can never be less than zero. See
Publication 551, Basis of Assets,
for more information on adjusted basis.
- Amounts recoverable through:
- Depreciation deductions,
- Deferred expenses (including deferred exploration and development costs), and
- Deductions other than depletion.
- The residual value of land and improvements at the end of operations.
- The cost or value of land acquired for purposes other than mineral production.
Total recoverable units. The total recoverable units is the sum of
You must estimate or determine recoverable units (tons, pounds, ounces, barrels,
thousands of cubic feet, or other measure) of mineral products using the current
industry method and the most accurate and reliable information you can obtain.
- The number of units of mineral remaining at the end of the year (including units
recovered but not sold).
- The number of units of mineral sold during the tax year (determined under your method
of accounting, as explained next).
Number of units sold. You determine the number of units sold during
the tax year based on your method of accounting. Use the following table to make
THEN the units sold during the year are ...
The cash method of accounting
The units sold for which you receive payment during the tax year (regardless of
the year of sale).
An accrual method of accounting
The units sold based on your inventories and method of accounting for inventory.
The number of units sold during the tax year does not include any for which depletion
deductions were allowed or allowable in earlier years.
Figuring the cost depletion deduction. Once you have
figured your property's basis for depletion, the total recoverable units, and the
number of units sold during the tax year, you can figure your cost depletion deduction
by taking the following steps.
Divide your property's
basis for depletion by
total recoverable units.
Rate per unit.
Multiply the rate per
unit by units sold
during the tax year.
Cost depletion deduction.
You must keep accounts for the depletion of each property and adjust these accounts
each year for units sold and depletion claimed.
Elective safe harbor for owners of oil and gas property.
Owners of oil and gas property may use an elective safe harbor in determining the
property's recoverable reserves for purposes of computing cost depletion. If this
election is made, special rules apply. See Revenue Procedure 2004-19 on page 563
of Internal Revenue Bulletin 2004-10, available at www.irs.gov/pub/irs-irbs/irb04-10.pdf.
To make the election, attach a statement to your timely filed (including extensions)
original return for the first tax year for which the safe harbor is elected. The
statement must indicate that you are electing the safe harbor provided by Revenue
Procedure 2004-19. The election, if made, is effective for the tax year in which
it is made and all subsequent years. It cannot be revoked for the tax year in which
it is elected, but may be revoked in a later year. Once revoked, it cannot be re-elected
for the next 5 years.
To figure percentage depletion, you multiply a certain percentage, specified for
each mineral, by your gross income from the property during the tax year.
The rates to be used and other conditions and qualifications for oil and gas wells
are discussed later under Independent Producers and Royalty
Owners and under Natural Gas Wells.
Gross income. When figuring your percentage depletion,
subtract from your gross income from the property the following amounts.
A bonus payment includes amounts you paid as a lessee to satisfy a production payment
retained by the lessor.
- Any rents or royalties you paid or incurred for the property.
- The part of any bonus you paid for a lease on the property allocable to the product
sold (or that otherwise gives rise to gross income) for the tax year.
Use the following fraction to figure the part of the bonus you must subtract.
No. of units sold in the tax year
Recoverable units from the property
For oil and gas wells and geothermal deposits, gross income from the property is
defined later under Oil and Gas Wells. For
property other than a geothermal deposit or an oil and gas well, gross income from
the property is defined later under Mines and Geothermal
Taxable income limit. The percentage depletion deduction
generally cannot be more than 100% for oil and gas property of your taxable
income from the property figured without the depletion deduction and the deduction
for domestic production activities under section 199 of the Internal Revenue Code.
Taxable income from the property means gross income from the property minus all
allowable deductions (excluding any deduction for depletion or qualified domestic
production activities) attributable to mining processes, including mining transportation.
These deductible items include the following.
The following rules apply when figuring your taxable income from the property for
purposes of the taxable income limit.
- Operating expenses.
- Certain selling expenses.
- Administrative and financial overhead.
- Intangible drilling and development costs.
- Exploration and development expenditures.
- Do not deduct any net operating loss deduction from the gross income from the property.
- Corporations do not deduct charitable contributions from the gross income from the
- If, during the year, you dispose of an item of section 1245 property that was used
in connection with mineral property, reduce any allowable deduction for mining expenses
by the part of any gain you must report as ordinary income that is allocable to
the mineral property. See section 1.613-5(b)(1) of the regulations for information
on how to figure the ordinary gain allocable to the property.
You cannot claim percentage depletion for an oil or gas well unless at least one
of the following applies.
- You are either an independent producer or a royalty owner.
- The well produces natural gas that is either sold under a fixed contract or produced
from geopressured brine.
If you are an independent producer or royalty owner, see
Independent Producers and Royalty Owners, next.
For information on the depletion deduction for wells that produce natural gas that
is either sold under a fixed contract or produced from geopressured brine, see Natural Gas Wells, later.
Independent Producers and Royalty Owners
If you are an independent producer or royalty owner, you figure percentage depletion
using a rate of 15% of the gross income from the property based on your average
daily production of domestic crude oil or domestic natural gas up to your depletable
oil or natural gas quantity. However, certain refiners, as explained next, and certain
retailers and transferees of proven oil and gas properties, as explained later,
cannot claim percentage depletion. For information on figuring the deduction, see
Figuring percentage depletion, later.
Refiners who cannot claim percentage depletion. For tax years
ending before August 9, 2005, you cannot claim percentage depletion if you or a
related person refine crude oil and you and the related person refined more than
50,000 barrels on any day during the tax year. For tax years ending after August
8, 2005, this limit is increased to 75,000 barrels, based on average (rather than
actual) daily refinery runs for the tax year. The average daily refinery run is
computed by dividing total refinery runs for the tax year by the total number of
days in the tax year.
Related person. You and another person are related
persons if either of you holds a significant ownership interest in the other person
or if a third person holds a significant ownership interest in both of you.
For example, a corporation, partnership, estate, or trust and anyone who holds a
significant ownership interest in it are related persons. A partnership and a trust
are related persons if one person holds a significant ownership interest in each
For purposes of the related person rules, significant ownership interest means direct
or indirect ownership of 5% or more in any one of the following.
- The value of the outstanding stock of a corporation.
- The interest in the profits or capital of a partnership.
- The beneficial interests in an estate or trust.
Any interest owned by or for a corporation, partnership, trust, or estate is considered
to be owned directly both by itself and proportionately by its shareholders, partners,
Retailers who cannot claim percentage depletion. You
cannot claim percentage depletion if both the following apply.
For the purpose of determining if this rule applies, do not count the following.
- You sell oil or natural gas or their by-products directly or through a related person
in any of the following situations.
- Through a retail outlet operated by you or a related person.
- To any person who is required under an agreement with you or a related person to
use a trademark, trade name, or service mark or name owned by you or a related person
in marketing or distributing oil, natural gas, or their by-products.
- To any person given authority under an agreement with you or a related person to
occupy any retail outlet owned, leased, or controlled by you or a related person.
- The combined gross receipts from sales (not counting resales) of oil, natural gas,
or their by-products by all retail outlets taken into account in (1) are more than
$5 million for the tax year.
- Bulk sales (sales in very large quantities) of oil or natural gas to commercial
or industrial users.
- Bulk sales of aviation fuels to the Department of Defense.
- Sales of oil or natural gas or their by-products outside the United States if none
of your domestic production or that of a related person is exported during the tax
year or the prior tax year.
Related person. To determine if you and another
person are related persons, see Related person
under Refiners who cannot claim percentage depletion,
Sales through a related person. You are considered to be
selling through a related person if any sale by the related person produces gross
income from which you may benefit because of your direct or indirect ownership interest
in the person.
You are not considered to be selling through a
related person who is a retailer if all the following apply.
- You do not have a significant ownership interest in the retailer.
- You sell your production to persons who are not related to either you or the retailer.
- The retailer does not buy oil or natural gas from your customers or persons related
to your customers.
- There are no arrangements for the retailer to acquire oil or natural gas you produced
for resale or made available for purchase by the retailer.
- Neither you nor the retailer knows of or controls the final disposition of the oil
or natural gas you sold or the original source of the petroleum products the retailer
acquired for resale.
Transferees who cannot claim percentage depletion. You
cannot claim percentage depletion if you received your interest in a proven oil
or gas property by transfer after 1974 and before October 12, 1990. For a definition
of the term “transfer,” see section 1.613A-7(n) of the
regulations. For a definition of the term “interest in proven oil
or gas property,” see section 1.613A-7(p) of the regulations.
Figuring percentage depletion. Generally, as an independent
producer or royalty owner, you figure your percentage depletion by computing your
average daily production of domestic oil or gas and comparing it to your depletable
oil or gas quantity. If your average daily production does not exceed your depletable
oil or gas quantity, you figure your percentage depletion by multiplying the gross
income from the oil or gas property (defined later) by 15%. If your average daily
production of domestic oil or gas exceeds your depletable oil or gas quantity, you
must make an allocation as explained later under Average
daily production exceeds depletable quantities.
In addition, there is a limit on the percentage depletion deduction. See
Taxable income limit, later.
Average daily production. Figure your average daily
production by dividing your total domestic production of oil or gas for the tax
year by the number of days in your tax year.
Partial interest.. If you have a partial interest
in the production from a property, figure your share of the production by multiplying
total production from the property by your percentage of interest in the revenues
from the property.
You have a partial interest in the production from a property if you have a net
profits interest in the property. To figure the share of production for your net
profits interest, you must first determine your percentage participation (as measured
by the net profits) in the gross revenue from the property. To figure this percentage,
you divide the income you receive for your net profits interest by the gross revenue
from the property. Then multiply the total production from the property by your
percentage participation to figure your share of the production.
John Oak owns oil property in which Paul Elm owns a 20% net profits interest. During
the year, the property produced 10,000 barrels of oil, which John sold for $200,000.
John had expenses of $90,000 attributable to the property. The property generated
a net profit of $110,000 ($200,000 - $90,000). Paul received income of $22,000 ($110,000
× .20) for his net profits interest.
Paul determined his percentage participation to be 11% by dividing $22,000 (the
income he received) by $200,000 (the gross revenue from the property). Paul determined
his share of the oil production to be 1,100 barrels (10,000 barrels × 11%).
Depletable oil or natural gas quantity. Generally, your
depletable oil quantity is 1,000 barrels. Your depletable natural gas quantity is
6,000 cubic feet multiplied by the number of barrels of your depletable oil quantity
that you choose to apply. If you claim depletion on both oil and natural gas, you
must reduce your depletable oil quantity (1,000 barrels) by the number of barrels
you use to figure your depletable natural gas quantity.
You have both oil and natural gas production. To figure your depletable natural
gas quantity, you choose to apply 360 barrels of your 1000-barrel depletable oil
quantity. Your depletable natural gas quantity is 2.16 million cubic feet of gas
(360 × 6000). You must reduce your depletable oil quantity to 640 barrels (1000
If you have production from marginal wells, see section 613A(c)(6) of the Internal
Revenue Code to figure your depletable oil or natural gas quantity.
Business entities and family members. You must
allocate the depletable oil or gas quantity among the following related persons
in proportion to each entity's or family member's production of domestic oil or
gas for the year.
For purposes of this allocation, a related person is anyone mentioned under Related persons in chapter 12 except that item
(1) in that discussion includes only an individual, his or her spouse, and minor
- Corporations, trusts, and estates if 50% or more of the beneficial interest is owned
by the same or related persons (considering only persons that own at least 5% of
the beneficial interest).
- You and your spouse and minor children.
Controlled group of corporations. Members of
the same controlled group of corporations are treated as one taxpayer when figuring
the depletable oil or natural gas quantity. They share the depletable quantity.
Under this rule, a controlled group of corporations is defined in section 1563(a)
of the Internal Revenue Code, except that the stock ownership requirement in that
definition is “more than 50%” rather than “at
Gross income from the property. For purposes of percentage
depletion, gross income from the property (in the case of oil and gas wells) is
the amount you receive from the sale of the oil or gas in the immediate vicinity
of the well. If you do not sell the oil or gas on the property, but manufacture
or convert it into a refined product before sale or transport it before sale, the
gross income from the property is the representative market or field price (RMFP)
of the oil or gas, before conversion or transportation.
If you sold gas after you removed it from the premises for a price that is lower
than the RMFP, determine gross income from the property for percentage depletion
purposes without regard to the RMFP.
Gross income from the property does not include lease bonuses, advance royalties,
or other amounts payable without regard to production from the property.
Average daily production exceeds depletable quantities.
If your average daily production for the year is more than your depletable oil or
natural gas quantity, figure your allowance for depletion for each domestic oil
or natural gas property as follows.
- Figure your average daily production of oil or natural gas for the year.
- Figure your depletable oil or natural gas quantity for the year.
- Figure depletion for all oil or natural gas produced from the property using a percentage
depletion rate of 15%.
- Multiply the result figured in (3) by a fraction, the numerator of which is the
result figured in (2) and the denominator of which is the result figured in (1).
This is your depletion allowance for that property for the year.
Taxable income limit. If you are an independent producer
or royalty owner of oil and gas, your deduction for percentage depletion is limited
to the smaller of the following.
You can carry over to the following year any amount you cannot deduct because of
the 65%-of-taxable-income limit. Add it to your depletion allowance (before applying
any limits) for the following year.
- 100% of your taxable income from the property figured without the deduction for
depletion and the deduction for domestic production activities under section 199
of the Internal Revenue Code. For a definition of taxable income from the property,
see Taxable income limit, earlier, under
- 65% of your taxable income from all sources, figured without the depletion allowance,
the deduction for domestic production activities, any net operating loss carryback,
and any capital loss carryback.
For 2005, depletion on the marginal production of oil or natural gas is not limited
to your taxable income from the property figured without the depletion deduction.
For information on marginal production, see section 613A(c)(6) of the Internal Revenue
Partnerships and S Corporations
Generally, each partner or shareholder, and not the partnership or S corporation,
figures the depletion allowance separately. (However, see Electing large partnerships
must figure depletion allowance, later.) Each partner or shareholder must
decide whether to use cost or percentage depletion. If a partner or shareholder
uses percentage depletion, he or she must apply the 65%-of-taxable-income limit
using his or her taxable income from all sources.
Partner's or shareholder's adjusted basis. The partnership
or S corporation must allocate to each partner or shareholder his or her share of
the adjusted basis of each oil or gas property held by the partnership or S corporation.
The partnership or S corporation makes the allocation as of the date it acquires
the oil or gas property.
Each partner's share of the adjusted basis of the oil or gas property generally
is figured according to that partner's interest in partnership capital. However,
in some cases, it is figured according to the partner's interest in partnership
The partnership or S corporation adjusts the partner's or shareholder's share of
the adjusted basis of the oil and gas property for any capital expenditures made
for the property and for any change in partnership or S corporation interests.
Each partner or shareholder must separately keep records of his or her share of
the adjusted basis in each oil and gas property of the partnership or S corporation.
The partner or shareholder must reduce his or her adjusted basis by the depletion
allowed or allowable on the property each year. The partner or shareholder must
use that reduced adjusted basis to figure cost depletion or his or her gain or loss
if the partnership or S corporation disposes of the property.
Reporting the deduction. Information that you, as a
partner or shareholder, use to figure your depletion deduction on oil and gas properties
is reported by the partnership or S corporation on line 20 of Schedule K-1 (Form
1065) or on line 17 of Schedule K-1 (Form 1120S). Deduct oil and gas depletion for
your partnership or S corporation interest on line 20 of Schedule E (Form 1040).
The depletion deducted on Schedule E is included in figuring income or loss from
rental real estate or royalty properties. The instructions for Schedule E explain
where to report this income or loss and whether you need to file either of the following
Electing large partnerships must figure depletion allowance.
An electing large partnership, rather than each partner, generally must figure
the depletion allowance. The partnership figures the depletion allowance without
taking into account the 65-percent-of-taxable-income limit and the depletable oil
or natural gas quantity. Also, the adjusted basis of a partner's interest in the
partnership is not affected by the depletion allowance.
- Form 6198, At-Risk Limitations.
- Form 8582, Passive Activity Loss Limitations.
An electing large partnership is one that meets both the following requirements.
Disqualified persons. An electing large partnership
does not figure the depletion allowance of its partners that are disqualified persons.
Disqualified persons must figure it themselves, as explained earlier.
- The partnership had 100 or more partners in the preceding year.
- The partnership chooses to be an electing large partnership.
All the following are disqualified persons.
- Refiners who cannot claim percentage depletion (discussed under
Independent Producers and Royalty Owners, earlier).
- Retailers who cannot claim percentage depletion (discussed under
Independent Producers and Royalty Owners, earlier).
- Any partner whose average daily production of domestic crude oil and natural gas
is more than 500 barrels during the tax year in which the partnership tax year ends.
Average daily production is discussed earlier.
Natural Gas Wells
You can use percentage depletion for a well that produces natural gas either sold
under a fixed contract or produced from geopressured brine.
Natural gas sold under a fixed contract. Natural gas
sold under a fixed contract qualifies for a percentage depletion rate of 22%. This
is domestic natural gas sold by the producer under a contract that does not provide
for a price increase to reflect any increase in the seller's tax liability because
of the repeal of percentage depletion for gas. The contract must have been in effect
from February 1, 1975, until the date of sale of the gas. Price increases after
February 1, 1975, are presumed to take the increase in tax liability into account
unless demonstrated otherwise by clear and convincing evidence.
Natural gas from geopressured brine. Qualified natural
gas from geopressured brine is eligible for a percentage depletion rate of 10%.
This is natural gas that is both the following.
- Produced from a well you began to drill after September 1978 and before 1984.
- Determined in accordance with section 503 of the Natural Gas Policy Act of 1978
to be produced from geopressured brine.
A lessor's gross income from the property that qualifies for percentage depletion
usually is the total of the royalties received from the lease. However, for oil
or gas, gross income does not include lease bonuses, advanced
royalties, or other amounts payable without regard to production from the property.
Bonuses and advanced royalties. Bonuses and advanced royalties
are payments a lessee makes before production to a lessor for the grant of rights
in a lease or for minerals, gas, or oil to be extracted from leased property. If
you are the lessor, your income from bonuses and advanced royalties received is
subject to an allowance for depletion.
Figuring cost depletion. To figure cost depletion
on a bonus, multiply your adjusted basis in the property by a fraction, the numerator
of which is the bonus and the denominator of which is the total bonus and royalties
expected to be received. To figure cost depletion on advanced royalties, use the
computation explained earlier under Cost Depletion,
treating the number of units for which the advanced royalty is received as
the number of units sold.
Figuring percentage depletion. In the case
of mines, wells, and other natural deposits other than gas or oil, you may use the percentage rates
Any bonus or advanced royalty payments are generally part of the gross income from
the property to which the rates are applied in making the calculation. However,
in the case of independent producers and royalty owners of oil and gas property,
bonuses and advance royalty payments are not a part of gross income.
Terminating the lease. If you receive a bonus
on a lease that expires, terminates, or is abandoned before you derive any income
from the extraction of mineral, include in income for the year of expiration, termination,
or abandonment, the depletion deduction you took. Also increase your adjusted basis
in the property to restore the depletion deduction you previously subtracted.
For advanced royalties, include in income for the year of lease termination, the
depletion claimed on minerals for which the advanced royalties were paid if the
minerals were not produced before termination. Increase your adjusted basis in the
property by the amount you include in income.
Delay rentals. These are payments for deferring development
of the property. Since delay rentals are ordinary rent, they are ordinary income
that is not subject to depletion. These rentals can be avoided by either abandoning
the lease, beginning development operations, or obtaining production.